Speculative activity surges in the global economy

Speculative activity on global financial markets has
increased sharply over the last two or three years. Hedge funds, which use
short-term, high-risk strategies, have been leading this trend. The number of
hedge funds is multiplying fast, and they are manipulating ever-bigger volumes
of speculative capital. Intensified speculation is always a symptom of an
approaching crisis in the world capitalist economy. LYNN WALSH writes.

ONE MEASURE OF the surge in speculative activity is the
sharp rise in foreign exchange (FX) dealing. In September 2004 the Bank for
International Settlements (BIS) published its sixth triennial survey of foreign
exchange and derivatives trading activity. (BIS press release, 28 September
2004, www.bis.org) Average daily global turnover in traditional FX markets rose
to $1.9 trillion in April 2004, up by 57% at current exchange rates and by 36%
at constant exchange rates compared to April 2001.

Another measure is the trade in derivatives, which are
complex, security-like instruments for trading equities (shares), bonds,
currency, futures, options, swaps, etc. Derivatives trading also increased
sharply. The average daily turnover in trade of derivatives sold by banks
(so-called ‘over the counter’ (OTC) derivatives) increased to $1.2 trillion in
April 2004, a rise of 112% at current exchange rates and of 77% at constant
exchange rates compared to April 2001.

Only a small fraction of this foreign exchange is required
to finance cross-border trade of goods and services. Most of it is being used to
trade in securities (shares, government and private bonds, etc), derivatives,
commodity futures, etc, and increasingly to gamble on currency markets
themselves.

The growing dominance of financial activity over production
and trade points to the deep-rooted crisis within world capitalism. Massive
global over-capacity in most major industries has resulted in saturated markets
and falling prices for many manufactured goods. There are always some new growth
sectors and regions but, overall, scope for profitable investment in production
has not kept pace with the accumulation of capital.

The international capitalist offensive against the working
class in the 1980s and 1990s intensified the exploitation of workers everywhere.
Existing inequalities were widened, dramatically increasing the share of the
wealth taken by the capitalist class. At the same time, the squeeze on wages and
cuts in public spending, together with stagnation or decline in most
underdeveloped countries, restricted the growth of effective (money-backed)
demand. Unable to harvest sufficient profits from productive investment (either
through intensive investment in new technology or through extensive development
across the whole world), the hyper-rich ruling class has increasingly turned to
speculation in the financial sector. Money is churned to make more money,
skipping the intermediary stage of producing useful goods and services. Never
has capitalism been more parasitic.

Cyclical trends in the 1990s

THERE WAS AN enormous and continuous increase in speculative
activity during the decade of the 1990s, the period of accelerated
‘globalisation’ (mainly based on investment in a handful of Asian countries) and
the US-dominated bubble economy. BIS figures for global FX market turnover show
that daily average turnover (at April 2004 exchange rates) increased from $650
billion in April 1989 to $1,590 billion in April 1998. (BIS Quarterly Review,
December 2004, p68)

This acceleration of currency trading, however, was
interrupted between 1998 and 2001, when there was actually a fall in average
daily turnover from $1,590 billion to $1,380 billion. The BIS attributes part of
this decline to the launch of the euro and an accelerated concentration of major
banks, which reduced demand for foreign currency, especially in Europe. The main
reason for the decline, however, was the 1997-98 global economic crisis, with
the Asian currency turmoil and slump, the collapse of the Russian bond market,
and the near-collapse of the US hedge fund, Long Term Capital Management (LTCM).
There was a sharp reduction of liquidity on world financial markets. Banks,
financial institutions and wealthy investors temporarily curbed some of their
more risky speculative activity. The 1997-98 crisis, moreover, was followed at
the end of 2000 by the collapse of the stock exchange bubble.

Since 2001 there has been a new surge in FX markets.
Following the collapse of the stock exchange bubble in 2001, big investors were
no longer able to make big profits through trading in equities (company shares).
At the same time, low interest rates, especially in the US (where the inflow of
foreign funds allowed the Fed to reduce the base rate to 1%), depressed the
profitability of trading on bond markets. Speculators therefore turned
increasingly to buying and selling currency as a source of profit.

Mainly using the US dollar, the Japanese yen and the Swiss
franc, big speculators followed the strategy of investing in currencies of
national economies offering higher interest rates or in currencies tending to
appreciate over a sustained period. "A popular form of this investment strategy
was the so-called ‘carry trade’. In a carry trade, an investor borrows in a low
interest rate currency, such as the US dollar, and then takes a long position
[buying FX] in a higher interest rate currency, such as the Australian dollar,
betting that the exchange rate will not change so as to offset the interest rate
differential". (Galati and Melvin)

Of course, speculative flows into a high interest rate
currency will themselves tend to push up its value against other currencies. The
UK pound is one of the ‘target’ currencies pushed up by this kind of speculative
flow. Recently, there have also been big speculative flows into the Chinese
renminbi (RMB, also known as the yuan), with some hedge funds betting that the
Chinese government will break the current peg with the US dollar ($1 = 8.28 yuan)
and substantially revalue its currency (a development which is far from certain
in the near future).

Hedge funds lead the herd

A WIDE SPECTRUM of big investors is involved in currency
trading: financial institutions (insurance companies and pension funds),
currency and commodity dealers, commercial banks – and hedge funds. While hedge
funds are not the biggest players, they often appear to be the ‘lead steers’ in
the ‘herding’ activity of speculators, leading the stampede in episodes of
intensified volatility.

Hedge funds were implicated in the October 1992 collapse of
the European Exchange Rate Mechanism (ERM), when George Soros’s Quantum Fund
made over $1 billion speculating against the UK pound on ‘Black Wednesday’, and
in the 1994 crisis in international bond markets. During the 1997 Asian crisis
Soros was accused (by Mohamad Mahathir, the Malaysian premier, among others) of
breaking the ringgitt and other regional currencies. In 1998 the near collapse
of the US hedge fund LTCM brought the world financial system to the brink of
meltdown.

The recent multiplication of the number of hedge funds and
their ever more adventurous activities have again focussed attention on their
role. Under the headline ‘Voracious traders set market running’, a feature in
the (London) Times (Richard Irving, 8/9 November 2004) reported on the increase
in hedge fund activity. The feature reflected fears among some capitalist
leaders about the destabilising effects of the predatory activity of hedge
funds. ("Hedge fund aspirations may have to be trimmed".) Some commentators are
particularly concerned by the growing trend of big company and local government
pension funds to invest in hedge funds, which undoubtedly exposes workers’
retirement savings to even greater risks than before.

The number of hedge funds has been growing rapidly, doubling
over the last five years. There are now estimated to be about 9,000
internationally, controlling about $1 trillion of investors’ assets. On the
strength of these assets, they are estimated to have borrowed between $1.5 and
$2 trillion – giving them control of up to $3 trillion assets (with around half
based in the US). This is only a small fraction of total global investment
assets, perhaps 4% to 5% of the global institutional investment assets of
advanced capitalist countries (which were about $54 trillion at the end of
2003). Moreover, most hedge funds are relatively small, managing assets under
$500 million. For various reasons, however, hedge funds have a disproportionate
impact on markets. The ‘ripple’ effects of a hedge fund collapse could have a
devastating effect on the world financial system.

Commenting on the role of hedge funds, Paul Woolley, head of
GMO Europe (an investment management firm), says: "We are moving towards a
highly polarised [investment market] structure in which the behaviour of the few
[hedge funds, etc] is shaping markets for the many [financial institutions]".
(How hedge funds are destabilising the markets, Financial Times, 28 September
2004)

On the one side, over 95% of funds are managed by big
institutions (pension funds, insurance companies, mutual funds, etc) that
generally follow a passive investment policy, aiming to achieve returns roughly
in line with the main stock exchange share indexes (for example, S&P 500, FTSE
100, etc). On the other side, are hedge funds (now being joined by some other
investment groups), which actively manage their portfolios, seeking a higher
rate of return. Rather than holding a balanced portfolio, they tend to
concentrate on particular segments of the market, and use more risky strategies
like leveraging, short selling, and derivatives trading. Falling returns on a
broad range of investments since the bubble burst in 2000 have led more
investors to turn towards hedge funds – which appear to offer bigger short-term
profits. Also, other institutions (like the trading arms of investment banks and
some pension funds) have begun to adopt the hedge funds’ methods.

Hedge funds, explains Woolley, are "acquiring a pivotal role
in determining securities prices" (equities, bonds, derivatives, etc). This is
partly because of leveraging (which may more than double the sums they are
gambling with) and partly because they are actively buying and selling much more
frequently than big financial institutions. "As a result", says Woolley, "hedge
funds account for a far higher proportion of trading volumes than they do of
assets managed. In the US and UK, for example, their activity already accounts
for about 40% and sometimes as much as 70% of daily trading in equity markets".

Moreover, hedge funds thrive in volatile markets. One hedge
fund tactic is so-called ‘momentum investing’, where they follow rising or
falling trends in security prices, betting that they will later be able to
profit from eventual ‘corrections’ of over- or under-priced securities. In many
cases, the ‘momentum’ tactic actually amplifies the swing in the market,
increasing volatility.

"This combination of activity and the search for
volatility", warns Woolley, "means that, in certain situations, hedge funds have
become the marginal, price-determining investors… The fact is that unstable
markets provide hedge funds with their ideal conditions. But unstable markets
lead to an inefficient allocation of capital, impede economic growth, and can
cause turmoil in financial sectors. Unless greater balance can be restored
between the investment approaches that now dominate, the markets will become
less stable and less efficient".

But who can ‘restore balance’ in the anarchic market system
of capitalism? The recent burgeoning of hedge funds and their high-risk,
short-term speculative methods is not simply the result of irresponsible,
‘unbalanced’ investment strategies on the part of a minority of investors. The
speculative surge is a symptom of the organic crisis of capitalism, which arises
from the system’s contradictory logic. Instead of the restoration of ‘balance’,
wider sections of capitalists are turning towards hedge funds or independently
adopting their methods. This is despite indications that intensified competition
between more and more hedge funds, in almost totally integrated global financial
markets, is undermining their profitability.

Hedge fund profits lagging behind

"FOR HEDGE FUNDS overall last year, performance was less
than stellar. The Standard & Poor’s Hedge Fund index showed a year-to-date
return of 3.79% through December 28, less than half the gain in the S&P 500
[share index] of 8.99% last year. In 2003, the hedge fund index rose a healthy
11.12%, but the gain in the S&P 500 was more than double that, up 26.38%".
(Kevin Maler, From simple to complex, hedge funds gain ground, New York Times, 3
January 2005) Some speculators, however, claim that (unlike the big financial
institutions) hedge funds get above average returns in periods of market
downturn – provided, of course, they do not go bust.

Currently, 20% to 30% of hedge funds are wound up every
year. Some have recently made big losses. Last year the London-based Man Group,
the world’s largest stock-exchange-listed hedge fund operator, had negative
returns on its four main funds and lost $2.2 billion of its clients’ money.
Nevertheless, it continues to attract more money into its funds. Mega gamblers
are evidently ready to take the rough with the smooth.

But some commentators are asking whether hedge funds have
reached the limits of their success as high-profit investment vehicles. The
flood of funds and the multiplication of hedge funds have resulted in an
overcrowded marketplace. It is no longer a situation where a handful of maverick
funds (there were only around 200 in the early 1970s when Soros and co first
made their fortunes) are able to pounce on obscure corners of the market or
anomalously priced assets. All the tricks of the hedge fund trade are common
knowledge now. Intensive competition between thousands of funds has ironed out
the very ‘aberrations’ on which they previously relied for super profits.

And yet, not only is the flood of capital into hedge funds
still growing, but other financial entities are also adopting the same
high-risk, speculative tactics. The trading arms of investment banks are using
short trading, high leveraging, and derivatives on a big scale. This was clear
during the surge in oil prices in the last quarter of 2004, when speculation by
hedge funds and investment banks is estimated to have accounted for about 15% to
20% of the increase.

In their article in the BIS Quarterly Review, December 2004,
Gelati and Melvin show that the distinction between hedge funds and other
investment vehicles is being steadily eroded, especially (but not only) in
currency trading. Institutional investors (pension funds, insurance companies),
commodity trading advisers (CTAs – who advise companies and institutions), and
currency overlay managers (COMs – who advise on actively trading cash reserves)
have all begun to act like other types of funds, trading in currency, equities,
bonds, commodities, derivatives, etc. Increasingly, the only thing that
distinguishes hedge funds from other financial entities is their secretive,
unregulated character.

Some commentators, however, are particularly alarmed at the
growing involvement of pension funds in hedge funds. Faced with a global
shortfall of $1.5 trillion as a result of the post-2000 stock exchange slump,
many pension funds are desperately seeking higher returns. Since 2000 the
proportion of US and British pension funds investing in hedge funds has almost
doubled, from 12% to 23%. Moreover, over the last year pension funds investing
in hedge funds have increased their allocation in hedge funds by 36%, to around
$70 billion. Last year the chair of the US National Association of Pension Funds
"warn[ed] against over reliance on hedge funds, saying the industry is
inherently unstable because it uses leverage and seeks to generate long-run
returns from short-term horizons". (Hedge Funds: How risky bets can sneak into a
portfolio, International Herald Tribune, 10/11 April 2004) Clearly, the collapse
of one or more big hedge fund involving significant pension fund investments
could have a catastrophic effect on the security of workers’ pensions.

Another new source of investment capital for hedge funds is
the so-called ‘funds of hedge funds’. Operating like US mutual funds or British
unit trusts, they accept investments from small investors, with a low
participation threshold (for example, $2,500) and then invest their funds in
hedge funds. The global funds managed by funds of hedge funds grew 22% in 2004
and are currently estimated to be around €3 billion ($4bn). (International
Herald Tribune, 8 February 2005)

The accelerated growth of hedge funds and involvement of a
wider range of investors has led to demands from some sections of big business
for regulation, requiring them to register, disclose their activities and submit
to audits by the regulators. In the US, the Securities and Exchange Commission
(SEC) has begun to introduce a regulatory regime. Some hedge fund managers are
strongly opposed to any scrutiny of their activities and are currently
contesting the new SEC rules in the US courts. Others, however, welcome
regulation on the grounds that it will encourage greater participation in hedge
funds by financial institutions and small investors. The European Commission and
Britain’s Financial Services Authority (FSA) are both reviewing the role of
hedge funds, but seem in no hurry to subject them to a regulatory regime. Many
commentators take the view that if restrictive regulatory controls are
introduced many more hedge funds will simply transfer their operations to
offshore havens where they will be beyond the reach of regulators.

The crunch is coming

"BUSINESS IS ALWAYS thoroughly sound and the campaign in
full swing", wrote Karl Marx, "until the collapse suddenly overcomes them". Even
now, the global speculative surge is still gathering momentum. Recent interest
rate rises by the US Federal Reserve (with a current base rate of 2.5%) are
trailing behind the rising rate of US inflation (3.0%), bringing a reduction of
real (inflation adjusted) interest rates. The global tidal wave of excess
liquidity is actually growing, mocking Alan Greenspan’s timid ‘tightening’ of
monetary policy. This is fuelling even greater excesses of speculative
investment – with hedge funds leading the charge into ever more risky
adventures.

Two fields, in particular, have been prominent in recent
months. One has been the rush of ‘mergers and acquisitions’, highly leveraged
buy-outs financed by junk bonds – that is, high-yield, but high-risk company
bonds. The corporate predators that issue the bonds aim to pay high rates to
bond-holders (and big dividend bonuses to their own shareholders) through
asset-stripping the companies they swallow up. But many deals go wrong, and the
bonds become ‘junk’.

"The head of one of the biggest commercial lenders in the US
describes the amount of leverage [borrowing] on some buy-out deals as ‘nutty’.
Much of the wildest lending is being done by hedge funds awash with cash, he
says. ‘Some funds believe they have to invest the money even if it’s not a smart
investment. They think the people that gave them the money expect them to invest
it. But it’s madness’." (Dan Roberts, David Wighton and Peter Thal Larsen, The
end of the party? Financial Times, 14 March 2005) Roberts reports growing fears
that this cycle will end like the last one, "with a lot of over-leveraged
companies in trouble". Some commentators are raising the spectre of the major
junk bond crisis at the end of the 1980s boom.

Another newly fashionable field of risky speculative
investment is so-called ‘emerging market debt’. With low interest rates in the
US, Europe and Japan, speculators have recently been pumping cash into
government and company bonds in Brazil, Russia, Mexico, Colombia, Turkey and a
few other countries (mostly denominated in potentially volatile local
currencies). Such countries have to pay a ‘risk premium’ over US interest rates,
though this has been approximately halved recently – more by the flood of
liquidity than any reduction of risk. "All this is reminiscent of the mood that
preceded successive financial crises in the 1990s". (Roberts, The end of the
party?) Yet another debt bubble is being inflated to dangerous dimensions.

The complexity of the credit system, Marx long ago
commented, creates the illusion for capitalists that "capital produces money as
a pear tree produces pears", entirely divorced from production, the exploitation
of labour, and the realisation of profit through sales to consumers. Today, many
capitalists appear to believe that profits are conjured up on computer screens
from the virtual universe of electronic financial markets. Yet, a growing number
fear that a reality check is not far away. "The range of voices expressing
concern has widened. ‘The next time around is going to come sooner rather than
later’, says Paul Kirk, head of global restructuring at PwC, the professional
services firm. ‘The investment goals that are being pursued right now have
nothing to do with business fundamentals’." (Roberts, The end of the party?)

The low interest rate ‘regime’ on which the current
speculative bubble rests cannot last much longer. Exactly how it will end is
unpredictable. A collapse of one or more hedge funds or finance houses could
trigger a financial crisis. A sharp fall in the US dollar could force higher US
interest rates, bringing a fall in asset prices (equities, housing, junk bonds,
‘emerging market’ debt, etc) and a downturn in the US economy. Without an
expanding US market, China’s investment and property boom would collapse. The
end of the debt-financed US consumer boom would definitely mean the end of the
global party.

When will it happen? If only we could say. But the strategy
of a growing number of capitalists is "to gather more cash and wait for it to go
bang". (Roberts) The legendary financier, Warren Buffett, for instance, is
sitting on $45 billion of cash "waiting for a market correction". He, no doubt,
will be laughing. Billions of workers and poor people, who have nothing in the
bank except debts, will pay a terrible price for the greed-driven chaos and
bankruptcy of the capitalist system.

Note:

On 16 March 2005, the exchange rate for the US dollar was:
$1 = 0.5186 pounds or 0.7478 euro or 104.52 yen or 8.2765 yuan. Note that other
bilateral rates, for example the euro/yen rate, vary independently and cannot
simply be calculated from these values.

What are hedge funds?

HEDGE FUNDS ARE secretive clubs of mega-wealthy investors
(typically under 100 members). On the grounds that they are private
partnerships (not public companies) and their clients are all super rich (the
minimum investment is usually around one or two million dollars), they have
not been subject to regulation by financial authorities. In other words, they
have not been required to disclose their assets or activities. In any case,
many are registered in tax havens (Soros’s Quantum Fund is registered in
Curação, Netherlands Antilles). Recently, however, there have been moves,
especially in the US, to subject hedge funds to regulation.

Originally, hedge funds were supposed to be high-return
but relatively safe investment vehicles. Alfred Winslow Jones, who launched
the first hedge fund in 1949, developed the technique of ‘hedging’ (as in
‘hedging your bets’). For every share he bought ‘long’ (to hold for a period
on the assumption its price would rise) he bought another similar share
‘short’. The ‘short’ trading of shares means they are borrowed (usually from
brokers, with payment of interest) and sold quickly on the assumption that
their price will fall – allowing the hedge fund to buy them back more cheaply,
and return them to the lender at a profit. The idea is that the hedge fund can
gain whether share prices rise or fall. Hedge funds made high profits through
active, concentrated trading in targeted corners of financial markets,
attempting to identify ‘anomalies’ (for example, ‘under-valued’ shares to buy
‘long’ or ‘over-valued’ shares to sell ‘short’). They also exploited price
differences between different regional markets.

The profit per transaction may only be marginal. But Jones
used ‘leveraging’ to magnify the profits. This means borrowing big sums to
allow the hedge fund to buy and sell on a huge scale – activity that may
itself influence the fluctuations in share prices to the advantage of the
speculating funds. Far from being safe, however, both short selling and
leveraged trading are high-risk strategies.

Hedge funds today are still using short selling as a major
trading tactic. At the same time, they have increasingly diversified their
speculative activity from equities (shares) into every corner of the
international capitalist market: junk bonds (high-yield, high-risk company
bonds), commodities, currency, mergers and acquisitions (company takeovers),
etc.

Offering high returns, hedge funds have been able to
attract a growing number of super-rich investors, in spite of the risks
involved. "Over the last decade, hedge funds have delivered returns almost
four times that of equity markets". (Hedging smarter, International Herald
Tribune, September 2004) Investors have to put in an initial stake of at least
$1 million to $2 million. Hedge fund managers charge them 2% commission
(compared to an average 1.36% for US mutual funds – equivalent of British unit
trusts) and also charge a ‘performance fee’ of 20% of profits. Some hedge
funds have made their mangers fabulously rich from their own investments and
management fees. Soros, for instance, is estimated to have a personal fortune
of over $11 billion. Recently, it has been reported that a ‘publicity-shy’ US
hedge fund magnate, Steven Cohen, who manages funds worth $6 billion, has a
personal net worth of $2 billion, taking home $350 million in 2003 and even
more in 2004. In the last five years he has spent over $500 million on his
private art collection, paying $12 million for Damien Hirst’s shark, $52
million for a Jackson Pollock and $25 million for an Andy Warhol painting.
(Thomas and Vogel: ‘Financial shark leaves tooth marks on art world’,
International Herald Tribune, 4 March 2005)

It is not only the hedge fund managers, however, who draw
grotesque incomes from the funds’ activities. The investment banks that handle
the funds’ trading activities are also raking in huge amounts in fees. "Such
is the voracity of the [hedge] funds’ trading that regulators estimate that
some investment banks are generating up to 40% of their total revenues through
dealing commissions charged to hedge funds". (The Times, 8 November 2004)

The collapse of LTCM

HEDGE FUNDS ARE inherently risky. Capitalist leaders are
still haunted by the near-collapse in 1998 of the US hedge fund, Long Term
Capital Management (LTCM), an event that came near to triggering a domino-like
collapse of the world financial markets. During 1995-97, LTCM made huge
profits for its investors, achieving total returns, after management fees, of
33.7%, compared with the average 29.3% return on S&P 500 shares. LTCM made
most of its profits through trading in bonds, swaps and options, exploiting
(often small) price differences between different markets. To magnify trading
gains, LTCM managers operated on the basis of very high leveraging. On capital
of $4.8 billion at the beginning of 1998 the hedge fund was playing the
markets with about £120 billion. This implied borrowing of 25 times capital.
In addition, LTCM was managing ‘off-balance-sheet’ (on the side) derivative
contracts with a notional value of about $1.3 trillion.

In August 1998 the Russian government defaulted on its
bonds, and the ruble slumped. This sent shock waves around financial markets,
particularly hitting Argentina, Brazil and other so-called ‘emerging markets’.
The turbulence in global bond markets precipitated a collapse of LTCM in
September. After huge losses, LTCM’s net asset was down to only $600 million,
while its exposure to the market was about $100 billion – implying borrowing
of 167 times assets. This was unsustainable: LTCM was effectively bankrupt.

"Fear[ing] its failure could precipitate a global
financial crisis", the New York Federal Reserve quickly intervened to organise
a private, $3.6 billion behind-the-scenes bailout. (Joseph Stiglitz,
Globalization and its discontents, 2002, p150) The Fed particularly feared
that a fire sale of LTCM’s bonds and derivatives would trigger a slump in
prices, draining liquidity from markets. Clearly, there was the danger of a
chain reaction of hedge fund and bank failures. The Fed organised a rescue of
LTCM by the banks that had extended credit to the hedge fund. "The rescue of
LTCM can be seen as an out-of-court bankruptcy-type reorganisation in which
LTCM’s major creditors became its new owners, hoping to salvage as much value
as possible". (Barry Eichengreen & Donald Mathieson, Hedge funds: what do we
really know? IMF Economic Issues 19, September 1999.)

A chain-reaction financial crisis in the advanced
capitalist countries themselves – which would undoubtedly have provoked a
slump in the world economy – was averted by the Fed’s rapid intervention. At
the time, the seriousness of the crisis was largely concealed from the public
by a conspiracy of silence on the part of capitalist leaders and the media.
Stiglitz comments: "The United States lectured everyone… about crony
capitalism and its dangers. Yet issues of the use of influence appeared front
and center… [among other incidents] in the bailout of LTCM". (Globalization
p178)